Something funny with the hedge funds

This FT article from Eoin Callan on private equity and hedge fund managers’ efforts to fight off taxes on deferred interests has a weird undertone to it. First of all, this:

House Democrats are determined to move ahead with new taxes, so the industry has concentrated its efforts on blocking threatened legislation in the Senate, courting influential figures such as Harry Reid, majority leader. Mr Reid was toasted by industry lobbyists recently at a party held at the luxurious Bellagio Hotel in Las Vegas. The event was billed as a moneyraiser for his special fund to get more Democrats elected – with generous donations suggested – and ended with a serenade by singer Barry Manilow. After the event, Mr Reid’s office indicated that the Senate leader continued to think it unlikely a bill to increase tax on carried interest would be passed before the end of this session. Lobbyists were anxious not to appear too gleeful.

So far, so run of the mill Democrats-showing-that-they-too-can-ramp-up-the-sleaze-to-11. But this is where it gets strange:

But while winning new friends, the industry is also gaining a reputation for making enemies that might haunt them as the political fight drags on. “These guys are not playing it well. They have hired too many people too quickly,” a senior Democratic tax staffer said. An industry lobbyist said: “A lot of good people are being hired, but some bozos too. They are trying to throw too much weight around but it is going to backfire.

“It is getting nasty: below the belt stuff; delving into people’s personal lives; crossing lines,” added the lobbyist, who was critical of colleagues but reluctant to repeat publicly allegations being made privately about lawmakers and congressional staff. People close to industry lobby groups such as the Private Equity Council and the Managed Funds Association are adamant they are not to blame for any sharp elbows thrown on Capitol Hill. Privately they tend to blame each other for black eyes to the industry’s reputation.

I may be wrong here, but it seems to me that Callan (who is an excellent and careful journalist, as best as I can tell from his previous articles) is suggesting that hedge fund lobbyists are blackmailing politicians and their aides over their personal lives, or doing the next best thing to it. Is there another plausible explanation that I’m missing here?

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Slightly off your chosen topic of blackmail etc: about the taxation of carried interest.

When this same thing was looked at in the UK (the enjoyment of taper relief) the only solution found was to raise capital gains tax for all business investment.

Simply declaring that carried interest is in fact income, not a capital gain, means that all sweat equity deals need to be so classified.

So can anyone think of a way in which “just” this carried interest can be taxed more highly, without throwing vastly larger chunks of other (arguably more entreprenurial and thus desirable) activity into the same higher tax bands?

I’ve certainly seen a lot of furore about the perceived unfairness of the way in which carried interest is taxed, but I’ve not seen any proposal to change the rate or method that doesn’t affect a large number of other things as well.

There is a distinction between “business assets” and “financial assets” which already exists in UK tax law for exactly that purpose – all that would be needed to do would be to draft sufficiently tightly worded language to reclassify private equity investment partnerships as “financial assets”.

Maybe I’m not understanding the problem correctly. We are talking about the fee paid to hedge fund managers for their work on the hedge fund. Whether paid in cash or equities, that is a fee for work done, which is to say ‘ordinary income’. It isn’t an investment, it is a fee. Why should taxing that at the ordinary rate have much to do with investing already earned money into a long term investment and getting capital gains treatment? Fees for services rendered are ordinary income.

I think it sounds more like it is being suggested that they are desperate to avoid such legislation so they are hiring every lobbying firm/person they can get hold of, and aren’t being careful about avoiding hiring ones with bad reputations for the more sleazy end of lobbying (i.e. the blackmailing side rather than just the bribery side), rather than necessarily deliberately hiring such.

But then guessing motives of such decisions is always chancy – it might also be something they think they can get away with, and then disown those firms that play beyond the line later – ‘we never expected them to do that‘ type of thing.

Why would that be surprising? Politics in a two party system leads to plenty of campaigning by digging up dirt on opposition figures, it isn’t hard to see that some groups that make their money gathering that sort of material to publicly embarass politicians could easily be amenable to gather it to apply pressure to politicians privately instead.

It would be surprising to find that professional hitmen work in lobbying. It is surprising to find that professional blackmailers work in lobbying; it is surprising to think that professional bodies would hire such lobbyists.

Isn’t the difference that blackmail doesn’t have to be absolutely blatent, unlike a professional hit; it can be done in ways that are legally almost impossible to prove that was the intent, even if it is clear to the victim what the implication was. Just bringing up some embarassing and supposedly private fact during a meeting by a lobbyist could be effective while being almost completely deniable as blackmail.

Isn’t the difference that blackmail doesn’t have to be absolutely blatent, unlike a professional hit;

“Guido here tells me, it be terrible if an accident should befall your nice family, God forbid. And he is reminding me that here you are, working so hard in Washington, a city with lots of random violence. It never hurts to be careful does it?”

The smartly-dressed Guido in fact says nothing; he merely cracks his knuckles in a display of well-practiced professionalism.

To try to answer Sebastian Holsclaw’s question, hedge funds take a percentage of the assets under their charge and a percentage of the profit (the so-called 2 and 20). I gather that they can argue that this is like interest and not income. But I am not a tax lawyer.

My favorite part is that the managers do not share in the losses of the fund, only in the profits.

I too am perplexed as to how hedge fund managers have been able to classify what is clearly income as ‘carried interest’. If anyone is capable of enlightening me, I would be delighted to learn. It sounds like some here have some idea of the distinction or there wouldn’t have been this talk of ‘sweat’ equity that I am not familiar with…

“To try to answer Sebastian Holsclaw’s question, hedge funds take a percentage of the assets under their charge and a percentage of the profit (the so-called 2 and 20).”

But that is method-of-payment for fees they earn. If they pay taxes on it and then invest for more than a year they can get capital gains treatment, but how do they get it when they first earn the payment. Compensation in equities doesn’t get you capital gains treatment–see executive stock options which are treated as ordinary income when exercised.

I think Sydd’s example is actually extortion. Blackmail is more along the lines of “it would be unfortunate if knowledge of your youthful experimentation with wet suits were to become more widely known, Congressman – the press being the prurient bastards that they are.”

You DO watch too much Italian TV Syd! The lesson, or one of them, learned from McCarthyism, was: The more specialized one’s profession, the easier it is to blackball them.

The higher up the ladder you go….the less effort it takes to pull you down. Professionally. And when you spend years and years and years of post grad, or post doc work, and money, you have a real vested interest to protect.

My talk of “sweat equity” was from my own viewpoint as someone who has started several small businesses (all of which, alas, remained small).
The actual equity investment in such a thing is often very small. What gets the entrepreneur his chunk of equity is the time put in attempting to grow the business. That appears to be, at least to me, income for his work just as much as carried interest is.

The actual equity investment in such a thing is often very small. What gets the entrepreneur his chunk of equity is the time put in attempting to grow the business. That appears to be, at least to me, income for his work just as much as carried interest is.

Yes, but if the entrepreneur is rewarded with equity for his services in running the business that equity is in fact considered as ordinary income at the time received. Capital gains treatment is only available when the business is sold. At that time the entrepreneur has already paid (or should have paid) ordinary income tax on the value of the equity at the time he received it. The capital gain comes when the equity is sold at a higher price.

“Yes, but if the entrepreneur is rewarded with equity for his services in running the business that equity is in fact considered as ordinary income at the time received.”

If he gets it by grant of share options, yes. But if, as is entirely normal, the entrepreneur sets up the deal at the beginning along the lines of “Yes, I know I’m only putting in £500 but I’ll also be managing it for the next 3 years so I get 40% of the equity” then that appears to me to be very much the same as carried interest. And currently, no, it’s not taxed as income.

Although I hesitate to disagree with dsquared about something closer (?) to his area of professional expertise, I do not think that the distinction between carried interest and capital gains is as easy to make as he implies. For more detail, see these posts (here and here) by Equity Private.

The short version is that high-priced lawyers and lobbyists are really good at putting “income” into whatever category is least taxed, however the tax code is constructed. And, moreover, off-share havens beckon.

If, in connection with the performance of services, property is transferred to any person other than the person for whom such services are performed, the excess of—
(1) the fair market value of such property …. over
(2) the amount (if any) paid for such property, shall be included in the gross income of the person who performed such services…

I’ve skipped a lot of business about restrictions nd transferability, etc.

As a practical matter the kind of transaction you are talking about often occurs when the company is organized, and the value of the equity is usually small, so there may be little practical effect. But the idea that you can dodge the tax by changing the time at which the grant is made does not seem correct to me.

A different case occurs, I think, when the equity is, in effect, given in exchange not for management services but for the contribution of an asset, often a piece of intellectual property, which forms a part of the business.